DC Insights

Unblocking the illiquids impasse in DC

BlackRock |23-Apr-2019

Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.

Alternative investments. When it comes to the defined contribution (DC) market, the term has typically been met with a resigned shrug. These investments – including ‘illiquids’ such as infrastructure or private equity have clear benefits. They are long-term assets, in that they typically have a more structured, long-term repayment schedule than listed assets such as equities. This should make them more aligned with members’ long-term investment needs. They also provide diversification and risk mitigation when compared to traditional stocks and bonds, plus access to investments which have shrunk from the public domain: the number of publicly-listed UK companies has gone down by around a third since 2008, while in the US this has halved since the late 90s.

But costs, regulation and operational considerations have continued to inhibit the adoption of illiquids. At the operational level, the complexity of less-than-daily valuations jar with the current industry infrastructure which is designed to facilitate daily switching. Challenges at the governance level include how to share risk across different membership age groups and how to fit performance-related charges within a predictable charge structure. These are challenges which have historically prompted industry to focus innovation efforts elsewhere.

Evolution is at hand

However, changes are afoot. I was delighted that we sponsored the recently-launched research paper from the Pensions Policy Institute (PPI) exploring the role of illiquids in DC. It is perfectly timed and well worth a read. On stage at the launch event we had a robust debate between Asset Management (BlackRock), Provider (NEST) and Regulator (David Farrar, DWP) and two things are absolutely apparent. Everybody involved believes there is a value in accessing illiquids – in the right structure, at the right price and used in the right way. But there are still hurdles to overcome and it is incumbent upon all involved in the creation and distribution of products to work closely together to solve these problems. Even more so given that the Department for Work and Pensions (DWP), HM Treasury and the Financial Conduct Authority (FCA) have recently consulted on the best way to enable DC schemes to invest a higher proportion of assets into less traditional asset types.

The PPI’s research addresses the perception that, under current regulations, schemes are restricted to investing in daily-priced assets and that this requirement is reinforced by the permitted links rules.  It addresses some of the evolution that providers and platforms will have to go through to make alternatives investing more viable.

What needs to happen now?

There is also no doubt that asset managers should look at pricing and performance more imaginatively and that large schemes will be able to use their scale to drive cost efficiency, but this will be an evolutionary process rather than a sudden switch.

So what are the next steps? The results of the recent consultations and the DWP providing clarity around intentions on the current 0.75% charge cap come first. I’m not yet convinced that trustees feel there is capacity within the current charge cap for illiquids without concerns that the cap could be breached under some (performance fee-related) circumstances. Providers and platforms will also need to be nudged along to make illiquids more accessible as the regulatory regime evolves. But let’s be clear, this is a seller’s market with illiquids in high demand from defined benefit schemes and insurers who do not have the same restrictions on cost. We need to get creative otherwise we may find ourselves elbowed to the back of the buffet.

It is an exciting time to be talking to clients about scheme design and their investment options. The evolution and increased adoption of illiquids will be a critical step as DC becomes the dominant source of retirement provision and, as the largest provider of funds in the UK DC market, we at BlackRock look forward to staying at the forefront of this change.